Question:

4.1 You’ve located an investment that pays 12 percent per year. That rate sounds good
to you, so you invest $400. How much will you have in three years? How much will
you have in seven years? At the end of seven years, how much interest will you have
earned? How much of that interest results from compounding?

Answer:

The future value factor for 12 percent and three years as follows:

(1 + r)t = 1.123 = 1.4049

Your $400 thus grows to:

$400 x 1.4049 = $561.97

After seven years, you will have:

$400 x 1.127 = $400 x 2.2107 = $884.27

Thus, you will more than double your money over seven years.Because you invested
$400, the interest in the $884.27 future value is $884.27 - 400 = $484.27. At 12
percent, your $400 investment earns $400 x .12 = $48 in simple interest every year.
Over seven years, the simple interest thus totals 7 x $48 = $336. The other $484.27 -
336 = $148.27 is from compounding.

4.2 Vincent Van Gogh's "Sunflowers" was sold at auction in 1987 for approximately
$36 million. It had been sold in 1889 for $125. At what discount rate is $125 the
present value of $36 million, given a 98-year time span?

Answer:

125 = 36,000,000 [1 / (1 + r)98]

(36,000,000 / 125)1/98 - 1 = r = .13685 = 13.685%

4.3 Suppose you want to buy some books for your finance class. You currently have
$500 and the books you want costs $600. If you can earn 6%, how long will you have
to wait if you don’t add any additional money?

Answer:

PV = -500; FV = 600;

I/Y = 6; CPT N = 3.13 years

Formula: t = ln(600/500) / ln(1.06) = 3.13 years

4.4 An investment offers a perpetual cash flow of $1000 every year starting from the
end of the period. The return you require on such in investment is 12%. What is the
value of this investment?

Answer:
The value of this perpetuity is:
Perpetuity PV = C/r = 1000/0,12 = $8.333,333

4.5 Suppose you are comparing loans from 2 companies.  The first offers you 7.24%
compounded quarterly while the second offers you a lower rate of 7.18% but
compounds interest weekly.  Without considering any other fees at this time, which
is the better term?

Answer:
At 7.24% compounded 4 times per year the effective annual rate calculated is=
i = (1 + r/m)m - 1 = (1 + 0.0724/4)^4 - 1 = 0.07439 or I = 7.4389%

At 7.18% compounded 52 times per year the effective annual rate calculated is=
i = (1 + r/m)m - 1 = (1 + 0.0718/52)^52 - 1 = 0.07439 or I = 7.4387%

So based on nominal interest rate and the compounding per year, the effective rate
is essentially the same for the 2 different loans.

4.6 Suppose you have just won the first prize in a lottery. The lottery offers you two
possibilities for receiving your prize. The first possibility is to receive a payment of
$10,000 at the end of the year, and then, for the next 15 years this payment will be
repeated, but it will grow at a rate of 5%.  The interest rate is 12% during the entire
period. The second possibility is to receive $100,000 right now. Which of the two
possibilities would you take?

Answer:
You want to compare the PV of the growing annuity to the PV of receiving $100,000
right now (which is, obviously just $100,000). So, here are the numbers:
C = $10,000
r = 0.12
g = 0.05
t = 16

PV = C x {1 – [(1 + g)/(1 + r)]t/r – g}

= $91,989.41 < $100,000, therefore, you would prefer to be paid out right now.